Friday, February 08, 2008

On Market Volatility & Downturns

Market downturns are historically difficult to gauge, ex ante, in terms of their depth and length.

Further, it would appear that no two are alike.

To wit, the proprietary long/short allocation signals we employ have been useful, but not perfect, in this downturn.

Developed in the timeframe of the technology bubble collapse early this decade, the two indicators which comprise the signal alerted us that a downturn worthy of exiting long positions and taking short ones was imminent.

However, the actual January S&P500 plunge of more than 6% came faster than the signal for it.

What went wrong?

I suspect two things are different, with respect to the indicators. One is the much larger amount of investment assets now controlled by fast-moving hedge funds, relative to early in the decade. The other is the sheer speed of market reaction, helped in part by modern, high-speed, multi-channel dissemination of business and other news.

I don't typically focus on daily market changes, at least for investing purposes. I follow the market on a daily basis, but more to remain in touch with investor sentiment than to attempt to take advantage of any short-term market moves.

Further, not only are no two market downturns exactly alike, due to the evolution of environments surrounding equity investment over time. There are also few significant lengthy equity market downturns to study. Thus, unlike performing quantitative research on what works in typically upward-trending S&P500 equity markets, doing research on lengthy down markets is much tougher because there's simply less data, from fewer instances. Perforce, the certainty with which one can draw inferences and build indicators is much less than that for long-allocation periods.

Nevertheless, my partner and I fretted that we should have seen, by the beginning of December, that a large-scale decay in equity values was looming.

As a result of our move to options portfolios last year, we had a string of call portfolios which, beginning in late October, were showing consistently worsening losses, despite gains in our companion small equity portfolio.

After revisiting our current indicators and making some ad hoc modifications, we were still dissatisfied with the sense that we were engaged in 'fine tuning' a rather less-sensitive pair of indicators.

As we discussed this, I conjectured that there was probably some much shorter-term volatility-oriented measure that might inform us. Perhaps a monthly-based measure of daily change.

Ironically, I had posted this piece on a measure we labelled MFQ, for "Market Fluctuation Quotient," in late November. In that post, I concluded,

"If you are a frequent trader, than the MFQ is relevant. It clearly captures the recent, heightened day-to-day volatility, when that term means changes in closing market value direction.

We, however, are longer-term investors. Even in our equity options portfolios. As such, the MFQ doesn't really affect our investment decisions very much.
Still, it's interesting to note how divergent the two different perspectives on market 'volatility' can be- a series of standard deviations of month-to-month S&P returns, and a series measuring S&P daily close sign changes.

Clearly, volatility is in the eye of the beholder, and his/her frame of reference."

Technically, that was correct. However, the MFQ, as my partner still complained, lacked a magnitude component.

Building on this, after our recent discussions of a few weeks ago, I went back to something more classic. Taking the daily S&P returns for each month since 1990, I calculated a straightforward standard deviation of daily total returns of the index.

When this is plotted with to one of our two existing allocation indicators, we believe the two become leading indicators of a significant, longish equity market downturn.

The degree to which the monthly intra-day standard deviation of the S&P rose significantly, and remained high, shortly before a pronounced and lengthy market downturn of 2001 and the recent spate of losing index months, is unerring.

When put in context by the other, existing indicator, labelled "Factor A" on the nearby chart, it is a perfect pairing of leading indicators. Factor A turns steadily down just when the intra-day standard deviation skyrockets, in advance of a market downturn. But either one, on its own, is not predictive.

Armed with this new indicator, we are viewing the current market turmoil through new lenses, and, thus, with a new perspective.

The monthly intra-day standard deviation rose ominously in November. Had we been using this measure at the time, when I wrote the prior, linked post, we would have been out of long positions as of December. And probably already into put portfolios.

January's standard deviation rose again, to near-November levels. The evolving value for February is near January's level.

We think it's going to be at least a few more months before it is safe to remain long in equities or their derivatives.

Thursday, February 07, 2008

More Market Populism on CNBC: Jim Cramer & Doug Dachille

This morning's CNBC Squawkbox program featured populist market commentator Jim Cramer as guest host. As is now typical, Cramer used his temporary platform to bash the Fed, Treasury Secretary Henry Paulson, and for good measure, economist Brian Wesbury.

For a brief segment, First Principles Capital Management debt instrument manager Doug Dachille also joined the conversation. A video clip of this segment can be seen here, at least for today, for free, on CNBC's website:

What struck me most about Cramer's comments was his unfailingly populist, pseudo-working-class focus in his diagnosis of the economy and financial markets conditions, and prescriptions for their condition.

Suffice to say, in Cramer's world, the economy is in near-Depression straits, financial markets are just inches away from meltdown, and the 'working poor' need forgiveness and bailouts.

For example, Cramer believes that we need to do whatever possible to reverse the recent trends in housing price declines. Nevermind that for going on four years, pundits have decried the rise in housing prices as unsustainable, unwarranted, and economically unhealthy. Affordability became a real concern at the peak of housing prices.

But Cramer says they need to be reflated. His big idea? Government intervention, of course!

He wants Federal mortgage agency guarantees expanded, particularly at the FHA. Additionally, he calls for a Fed rescue- read 'another bailout'- of instrument insurers, i.e., MBIA, AMBAC,

Along the way, Cramer predictably bashes the Fed, Bernanke and Paulson. He rails against the Governors, demanding lower rates and mortgage rate actions to save 'homeowners hanging by a thread.'

Paradoxically, though, in another typical Cramer behavior, he simultaneously acknowledges that as much as 25% of delinquent or defaulting mortgages were taken by speculators. He doesn't mention the other major recent finding- that fraudsters frequently scammed lenders for cash ostensibly going to buy homes.

Then Cramer launched into his recession jag. First, he ticked off retail softness, as recent and current retail sales reports have shown weaker-than-expected consumer spending. Then Dachille chimed in, going over the top and claiming there is significant joblessness, and jobless people don't spend money at retailers.

What's interesting here is that only yesterday, on Larry Kudlow's show, the most negative of his guests admitted that recent wages data reflected reduced hours worked, not actual layoffs. It was generally agreed that, while weak, GDP growth was remaining non-negative, as were incomes.

So if Dachille is a debt maven, and he is convincing with his knowledge of fixed income spreads, evidently that proficiency doesn't extend, for him, to reading recent macroeconomic reports.

Picking up on Dachille's mistaken comment, Cramer weighed in and smeared Brian Wesbury in a brief aside, as if merely saying it discredits Wesbury's careful, sensible analysis that we are not in a recession. For more details on that, see
this recent post, which includes a link to Wesbury's recent Wall Street Journal piece on the economy.

Cramer then declares,

"We're in the worst deflationary slump since the 1930s."

He continues to deride the Fed, claiming they want to punish borrowers and are out of touch with reality. Without citing any data, Cramer blithely disregards yesterday's Fed official's comments on looming inflationary pressures, and declares that we are, in fact, in the midst of a deflation.

For those of us trained in economics, we can observe that Cramer has confused inflation, which is a monetary phenomenon involving the loss of buying power of a currency, with liquidity, or the availability of capital.

An economy can experience deflation and a loss of liquidity. It can also experience inflation and adequate liquidity. But an economy can also experience inflation without any particular large-scale change in liquidity, such as in the US in the 1970s.

It could be that financial asset losses of the recent year have caused some consumers to consume less, feeling a (negative) wealth effect from the equity market effects of the recent credit market turmoil. But that does not mean we are, as an economy, experiencing severe price deflation.

In fact, as the Fed cuts interest rates, leading to the decline in the value of the dollar, expressed in other currencies, imported commodities, such as energy and metals, are becoming more expensive. That would be, ah, inflationary, Jim.

Doug Dachille, on the other hand, sensibly saw two outcomes of the ever-lower rates demanded by Cramer. He foresees either more excessive risk-taking by financial institutions, or no risk-taking at all, with banks simply buying higher-yielding, longer-term Treasuries.

Either alternative, Dachille noted, is unwanted.

Then, later in the hour, Cramer reversed himself and declared Wal-Mart's troubles to be self-inflicted. After having declared all retail in peril, and a general recession, Cramer accedes to Dana Telsey, a prominent and solid retail analyst, who contends that the big box retailers are in trouble, but the more nimble, smaller retailers are not.

Suddenly, Cramer forgot his earlier rant about widespread economic softness, signaled by Wal-Mart's disappointing January sales reports.

You have to remember, though, Jim Cramer is a conventional Wall Street liberal Democrat. It's a weird combination of buccaneer trading and capitalism for himself, but populist bailouts with Federal money for the "working poor," or even middle-class, from which he apparently came.

Thus, Cramer prefers, and demands, populist remedies to immediately end any economic or financial markets pain, no matter what the cause. If speculation and lax lending, securitization, rating and investing practices by private players and investors caused current credit market problems, so what? Just turn on the monetary taps and wash all those unpleasant losses away.

Long term inflation? Who cares? Again, remember, Cramer was a daily-focused hedge fund trader. He is on record as having shilled prices of securities his fund held via rumor and media manipulation, to make a buck for the day. Long term economics and financial market horizons for him may well be tomorrow afternoon.

It's a sobering, but important observation to make concerning Cramer and his ilk. There are those calling that we are on the brink of another Great Depression and market crash. Yet, more professionally-trained, well-regarded economists and analysts seem to think we are simply experiencing a natural part of the business cycle- slowing growth.

Confusing the two could be very damaging for the US economy, financial markets and dollar in the long term.

Wednesday, February 06, 2008

Is Apple's Golden Age Approaching An End?

My equity selection process began to include Apple in May of 2006. That's four months shy of two years in which it's been reasonably consistently included in the portfolio.

Having managed to better the S&P for quite a few years prior to the month of entry into my selections, Apple has now had a long, multi-year run of outperformance versus the S&P500 Index.

Maybe it's near an end. I know my partner won't want to hear this. He feels deeply about Apple's management and product strategies. For what it's worth, I agree with him.

But, unfortunately, that's not sufficient to keep Apple outperforming the index.

Today, as the firm announced a slew of new and improved products, reports indicated that, if anything, the company' faithful customers were actually angered. They felt deceived as larger-capacity and/or less expensive models were introduced just months after the last, pre-Christmas slate of new products.

Usually, one or more of three factors are involved in a company's cessation of consistent index outperformance.

One source is competition. In this case, that still doesn't seem to be Apple's weakness.

Another is anti-trust or regulatory pressure. Think Wal-Mart or Microsoft. Again, though, this doesn't seem to be a source of Apple's recent stock price problems.

Finally, there is the gradual, eventual catching up of investor expectations to a company's ongoing, though excellent, performance. It seems that something like this is now occurring.
Let's look at three Yahoo-sourced charts of Apple's stock price over time, including, in one case, the S&P500 Index as well.
In the first chart, we see Apple's stock performance for the past five years. With only a few brief declines, it's been on a steadily upward trajectory since 2003. From my proprietary research, I'm aware that Apple has already entered a zone in which significantly long periods of further outperformance are becoming less likely.
Looking at the next chart, Apple's price performance since 1985, it's clear that these last five years of outperformance have been unique in the company's history. Except for its brief spurt in the mid-1980s and late 1990s, the company's stock has actually treaded water for most of 12 years.
But this last run has been longer and steadier than the earlier ones. Consequently, it provides a longer, steadier performance track record for observers, i.e., analysts and investors, to finally get their expectations fixed for Apple's future performance.
Adding the S&P500 to the second chart, we get a clearer picture of Apple's performance relative to the market. Through 2000, it was essentially even for 15 years. For the next four, it actually underperformed the index.
The recent outperformance by Apple's stock of the index essentially means that the company has been surprising the market with its well-managed, consistent operational and financial performance.
Now, the firm's continual upgrading of products and price cuts are seeming to upset its customers. They feel that every time they buy an Apple product, a better price/performance version comes out within a year.
Meanwhile, such superb product development and price management is becoming expected by the market. And, honestly, the firm's dominance of the digital music player and content download business has become so solid and long-lived that it's natural for observers to wonder if the next move isn't downward.
AppleTV hasn't taken off as the platform crossover "killer product" it was intended to be. Recent new product introductions aren't apparently 'wowing' customers and reviewers.
Historically, after two years in my portfolio selections, companies are excluded due to my research on senescence. That is, I have found that, after a fairly continuous presence in my equity portfolios, companies begin to bear an outsized risk of failing to surprise the market with their performance. Thus, some lesser-known company has a higher probability of posting an S&P-beating total return than a well-known, still-operationally successful firm.
This occurred with my holding of Kohls some years ago. The same has been true of some bio-pharma companies, as well, like Gilead.
Sad to say, I think Apple is approaching this point. The odds of its being able to consistently, significantly outperform heightened investor expectations are probably dropping with each new month.
As always, time will tell. But the law of large numbers isn't on Apple's side this time.

Tuesday, February 05, 2008

Starbuck's Latest Turnaround Strategy

This weekend's Wall Street Journal's "Heard On The Street" column discussed Starbuck's turnaround strategy.

For the second time in a few days, I read an article about Starbucks in which the word "segmentation" is used in quotes?

What's with that?

The context is that, according to this piece,

"Mr. Schultz is looking at "segmentation." strategies that would provide an entry point for new customers amid a weak economy."

Now, it was news to me that the Seattle's Best Coffee brand is owned by Starbucks. I think that's fantastic, because I like that brand much better than their flagship one. And as I've written here, about Les Wexner's Limited Brands, it's can be a very smart way to market different product lines.

However, only a few months ago, I wrote this post, which noted, from another Wall Street Journal article of that timeframe,

" 'Much of that may not be Starbucks's fault. Pressures on consumer spending haven't made it any easier for Starbucks to increase sales, particularly because Starbucks's customer base has gradually broadened to include Americans with lower average incomes, a group more likely to cut back. This summer, a spike in dairy costs caused the company to implement its second price increase in less than a year.'

To me, the most telling sentences are those in the fourth paragraph which I have quoted from the article. The company, in order to sustain growth over the past few years, headed down market. Now, those less-wealthy customers are being more affected by recent economic events, including prices of gasoline and food, while even Starbucks' ingredients' price rises are driving them to increase prices, too."

So Starbucks is, in fact, looking to reposition itself with its lower-income, newer customers. Apparently through the provision of inexpensive, simple brewed coffee. The Journal piece suggests,

"...and adding a lower-priced tier inside its own stores would be tricky for a brand that built its reputation on upscale cachet."

No kidding. Mr. Schultz, have you taken a look at Wal-Mart's failed 'upmarket' retail strategy of a few years past? It flopped. In their case, new, upscale customers wouldn't rub elbows with lower ones, and Wal-Mart's merchandising was not credible.

In the Starbucks case, you can imagine hordes of teenagers fleeing Starbucks as lower-priced, un-chiche, lower-priced coffees are shoehorned into the stores.

Schultz is also ditching the breakfast sandwich menu. Surprisingly, according to the article, this accounts for about $35,000 of revenue per location per year. That equates to something like $100/day. Isn't that only about 20 breakfasts/day?

Perhaps what's surprising is that they even kept this offering for so long. And that, with McDonalds revving up their coffee offerings, along with the constant pressure from Dunkin' Donuts, anyone wanting food won't visit Starbucks at all now, when they can just buy the same thing, for less money, at either of the other two purveyors.

Schultz holds out hope for Starbucks' line of summer drinks to help it out in the second half of the year. But isn't that a seasonal effect? Don't they already have a summer drink menu?

As the article suggests,

"Starbucks was one of the first major consumer brands to be built using word of mouth- and there are few precedents for how to resurrect a tarnished brand that was built that way."

As the nearby, Yahoo-sourced price chart of Starbucks and the S&P, for the last three months, demonstrates, the coffee roaster's stock is essentially in free-fall.

Schultz has one heck of a job to try to rescue this firm. Personally, I think he's fighting the force of Schumpeterian dynamics. Competition and consumer tastes have altered the competitive and market landscapes since the firm's heyday of some years ago. It's unlikely that Schultz can regain its long term, consistently outperforming total return record anytime soon, if ever.

Monday, February 04, 2008

Google Weighs In On Microsoft's Takeover Attempt

This morning's Wall Street Journal contains a feature story on Google's self-insertion into Microsoft's bid to acquire Yahoo, about which I wrote here on Friday.

Rather than wax extensively about the various moves and counter moves, I'd like to dwell, instead, on the tremendous amount of bile and misinformation flowing around this event.

First we have Google disingenuously claiming that Microsoft's acquisition of Yahoo would dangerously concentrate 'competition' in the sectors affected. According to the Journal,

"Google identified instant messaging and Web email accounts as areas where a Microsoft-Yahoo combination would have "an overwhelming" market share. In the blog post, Google also questioned whether Microsoft could use its "PC software monopoly to unfairly limit the ability of consumers to freely access competitors' email, [instant messaging] and Web-based services." "

Is Schmidt nuts? How can there be a monopoly of free goods or services? Nobody in their right mind has to pay for 'instant messaging and Web email accounts' anymore. Nobody.

So how in the world could Microsoft and Yahoo somehow collude and monopolize this product/market? Where's the beef? Ad revenues? Google already controls that market. Adding the second and third-rate online advertisers' revenues from their own IM and email systems can't possibly worry Schmidt and Google.

Then we have Ballmer claiming that the combination will bring more 'creativity' to the sector.

Really? How's that going to happen?

Let's think about this. What is 'creative,' in this context? You would think that 'creative' would involve developing a truly new, non-imitative product or service from Microsoft.

Instead, the firm simply proposes to buy a failed quasi-competitor. Nothing created there.

Why isn't Microsoft using the roughly $25B premium it's willing to pay for Yahoo to develop truly creative products or services?

Probably because Ballmer (and Gates) failed at this, post-Office and Windows systems, for the past decade. They've bought businesses, like WebPC, that vanished into the giant maw that is Microsoft. Their MSN network has struggled constantly. The browser war 'victory' was hollow, in that it brought no added revenue, but alerted anti-trust regulators everywhere to Microsoft's predatory approaches.

All that is being 'created' in the Microsoft acquisition of Yahoo is the consolidation of eyeballs into the online websites of one, rather than two, firms. If Microsoft could better ad-related software, wouldn't they just do it, for less than $25B? Or already deploy it to MSN?

If Yahoo's system was so good, would it be in such trouble now?

How would combining two mediocre ad revenue systems, and their creators, magically introduce 'creativity' into that product/market?

Google's supposedly friendly gesture to Jerry Yang is the predictable result of Schmidt's animus toward Gates, Ballmer and Microsoft, as Dennis Kneale theorized, and on whose theory I wrote, here.

Ballmer's (and Gates') Microsoft's bid for Yahoo is, similarly, aimed at their nemesis, Schmidt and Google.

The reality is that Google has already won the online ad revenue and search wars. They really don't need to harass Microsoft anymore, or worry about who would be so bereft of their own ideas to have to buy Yahoo to get new ones.

And Microsoft is simply past its prime. And will stay past its prime. Buying Yahoo won't change that. If anything, I believe it will hasten the software maker's decline.

Simply put, what could Yahoo have, of value, that it can't already monetize? What, of value, could it bring Microsoft that the latter can't get for less than the $25B premium?

The more this deal circulates in the media, the worse it looks for Microsoft. And the worse Google's reaction looks.

The only winners, I maintain, continue to be the suffering current shareholders of Yahoo.